Mary Holm: Pitfalls on the level playing field

Q. Yes, okay I admit I was a Labour voter. And with concern I've observed the ongoing house price inflation crisis, brought on by Labour's inept immigration and financial policies. Now I cringe.

As I watched New Zealand overburden with debt, my financial social conscience dictated I should sell my house in 2001 to buy domestic and overseas shares. I'm now renting.

My shares are now worth over $400,000 and I'm comfortable with the 8 per cent compounding returns over the past five years, with maybe even better prospects long term.

I'm a tradesman who has worked 60-hour weeks to try to get ahead. This has meant paying triple the average New Zealand personal tax.

Now [Finance Minister Michael] Cullen wants capital gains tax on overseas shares but not on houses. This seriously offends my sense of what is good for New Zealand and me in the longer term.

So I'm considering hiding my money offshore and going to work in Australia, until this fiscal madness completes the cycle of reducing the average standard of living for Kiwis.

Is there an alternative? How can I get my overseas investments on a level playing field with houses?

A. It goes against the grain for me to say this, but perhaps the proposed tax changes will make that field sort of level.

Arguably, under the present tax laws, direct investments in international shares in the "Grey List" countries of Australia, Canada, Germany, Japan, Norway, Spain, the UK and the US get favourable treatment compared with investments in New Zealand shares and property.

How come? In all cases, dividends or rent are taxed but capital gains usually are not. So far, so good. But overseas companies tend to pay lower dividends than in New Zealand, keeping more of their profits to reinvest in their businesses. All things being equal, that leads to larger untaxed capital gains. Under the proposed changes, due to take effect in April next year, New Zealand shares will continue to be taxed as usual and Australian shares will be taxed like New Zealand ones.

Given that Aussie dividends are generally almost as big as Kiwi ones, that's more or less fair. And it provides us with one possible answer to your question. You could move all your overseas money to Australia.

That's not a great idea, though. Of all the sharemarkets in the world, the one that moves most like ours is Australia's. You get much better diversification if you invest beyond Australia - which I assume you have done.

And that's where the complications start. On direct investments in non-Australasian shares that originally cost less than $50,000 in total, the tax will be the same as on Australasian shares.

If the total cost was more than $50,000, not only will dividends be taxed but also a portion of capital gains - to make up for the fact that the dividends tend to be low.

Calculating the portion will be rather complicated. First, you look at the change in the value of your international portfolio over the year, including dividends and gains in share values.

Then work out 85 per cent of that. That is the maximum amount you will ever be taxed on that year's income.

In the year in question, however, you may pay less than that. There is a 5 per cent cap on your taxable return, with the extra being carried over into other years. It all catches up with you when you sell, unless you die first.

Explaining how the cap works under different dividend and capital gain or loss scenarios is a bit of a nightmare. Given that nothing is final yet, let's wait and hope that we end up with something easier to follow.

Broadly speaking, there is some logic to all of this. But I do have some strong reservations:

* Despite the fact that international shares have perhaps had preferential tax treatment thus far, many New Zealanders favour property investment and others favour local shares.

They would be far better diversified, though, if they spread their long-term investments offshore as well as at home.

I reckon we need more tax preference for international share investment, rather than less.

* Lumping Australian shares in with our's makes sense in several ways. I'm worried, though, that it will also exacerbate another tendency among New Zealanders - to put most or all of their offshore investment dollars in Australia. As I said above, that's not great for diversification.

* The proposed tax will apply partly to "unrealised" gains - gains that haven't yet been turned into cash by selling the shares.

The 5 per cent cap on taxable income reduces this problem. It means no direct investor will pay more than 2 per cent in tax, until they have sold their shares, and often dividends will provide most or all of that.

Still, there may be times when some people will be forced to sell some of their shares to pay the tax. That hardly encourages long-term investment.

All in all, I think the status quo is better.

In the meantime, here's some hope from Andrew Brockway of AMP Capital Investors: "We have been discussing the proposed changes with officials for some time. A number of our suggestions have been incorporated into the latest proposal.

"We are continuing our discussions and, in particular, I believe there is a case for a larger discount on the tax for foreign equity investments."

I agree. A lower percentage than 85 per cent would help.

And some advice from Suzanne de Vere of Tower Investments: "We think advisers and investors alike should not be making decisions until there is a lot more clarity on these and many other issues. While we expect the draft legislation (due to be released in May) will provide more clarity, the select committee process could result in yet further changes."

Hang fire.

* * *

Q. I am still not sure about the proposed tax changes to overseas shares.

I purchased a few years ago two lots of WiNZ international index fund shares. One lot of 40,000 cost $1 each and another lot of 27,000 cost $1.10 each.

How will the new tax changes affect me? I have read that if I own less than $50,000 (based on the initial cost) worth of overseas shares (WiNZ shares are my only overseas shareholding), I am exempt from the proposed tax on capital gains.

How can I reduce my holding to gain tax exemption?

A. I'm afraid the $50,000 exemption doesn't apply to investments in share funds, such as WiNZ.

The exemption is for people with small direct overseas investments, which means they own the shares themselves. "The Government felt that for a certain size of holding it's not worth people having to perform the calculations," says Treasury official Brock Jera. But in a share fund, the managers will do that work for you.

So how will the changes affect you?

First, WiNZ is an index fund - sometimes called a passive fund - which means it invests in the shares in a market index.

Currently, index funds don't pay tax on capital gains, unlike active funds, whose managers pick and choose what to invest in. But under the new law that distinction will no longer apply.

All share funds that invest in New Zealand or Australian shares - whether they are index or active funds - won't pay tax on capital gains. And all funds that invest elsewhere will pay tax on some gains.

More specifically, WiNZ investors are expected to be taxed on 85 per cent of the fund return, including dividends and capital gains, says Brockway. There is one small exclusion. Capital gains on Australian shares, which make up about 3 per cent of WiNZ, won't be taxed.

WiNZ investors in the 19.5 per cent bracket will be taxed at that rate. Those in the 33 or 39 per cent brackets will all be taxed at 33 per cent.

The 5 per cent cap mentioned in the previous Q&A doesn't apply to managed funds such as WiNZ. "But the rules are designed with the expectation that managed funds will manage their tax liability on behalf of unit holders," says Jera.

You won't suddenly find you have to sell units to cover your tax.

The changes will certainly reduce after-tax returns, although the difference won't be all that big in years when returns are modest. And when returns are high, investors won't mind the higher tax so much.

I still think international share funds will continue to be a good simple way to make a diversified international investment. I still favour index over active funds, largely because they are cheaper to run and so their fees are usually lower.

A note for direct investors in overseas shares: If the cost of your investments is between $50,000 and $100,000, you will be able to qualify for the under-$50,000 exemption by splitting your investment with a spouse, says Jera.

Officials haven't yet gone into detail on the use of family trusts for investment splitting. However, Jera says the exemption has been requested for some trusts, such as court-ordered trusts, but many other trusts probably won't receive it.